Description

Circle K Sunkus (3337) is the fourth largest convenience store chain in Japan.  At ¥1,242 per share, the company is valued at 0.8x tangible book value, 2.4x trailing EBITDA and 14x trailing earnings.  Adjusting for the excess cash on the company's balance sheet, it is trading at about 8.5x earnings and fully taxed free cash flow. This is remarkable when one considers:

• The company grew tangible book value every year since its creation in 2003.     
• Earnings have grown over the last twelve months.
• Same store sales grew in March, i.e., after the earthquake and Tsunami.
• The company consistently generates good returns on capital.

As the business is currently configured and performing, Circle K Sunkus shares could double in price and still not be considered over-valued; we plan to purchase Circle K Sunkus shares in the near future.

Valuation and capital structure

The following table summarizes Circle K Sunkus's current market valuation and capital structure.

Note that Circle K Sunkus has no debt and that 75% of its market capitalization is in cash (42% net of lease obligations): the company is overcapitalized. This presents a challenge for the analyst in that, in order to evaluate the quality of the underlying business, one must make an adjustment for the large cash balance. For instance, as the table at the top of page one shows, the average return on equity for 3337 since 2003 was about 7.5% - not very interesting. However, if one adjusts for the excess cash, e.g., assume that 90% of the cash is excess cash, the business generated an un-levered after tax return on equity of about 15%, which is quite respectable. We are not suggesting that it is wise or in shareholders' best interest for 3337 to retain so much cash, we are simply making the point that when evaluating the quality of the business, adjustment must be made for the excess cash.

Accounting for Leases

Japanese lease practices and accounting also complicate the analysis when one studies 3337 and its Japanese peers. We bring this to your attention now because leases are pertinent to the company's capital structure and lease costs are very relevant to the company's economics.

Circle K Sunkus's lease costs totaled ¥50.6 billion for the year ended 2/28/11 making lease costs the second largest cost (behind cost of goods sold) for the company. The company includes lease costs in SG&A; we have broken-out their historical lease costs on our version of their income statement included at the back of this report. Three points regarding 3337's leases:

Firstly, Circle K Sunkus leases retail space principally under what it calls "long-term cancelable lease agreements." These agreements may be canceled on a few months notice, so they aren't long-term in the traditional accounting sense (e.g., they may be canceled on less than one year's notice).  In exchange for this flexibility, the company deposits funds with landlords equivalent to several months rent.  These deposits bear no interest and are refundable upon lease termination. As a result, substantially all of Circle K Sunkus's lease obligations are short-term in nature and are included on the balance sheet as an asset ("lease deposits") with no offsetting liability. Because the company has no liability in excess of the "lease deposit" asset, we do not include an entry for these leases in the company's capital structure when calculating its enterprise value, i.e., the ¥43.6 billion lease deposit asset is supported by the company's other liabilities and equity.

A second group of leases (for store fixtures and equipment) is included as an asset (included in property, plant and equipment) on Circle K Sunkus's balance sheet. These leases have corresponding liabilities, split between current liabilities (included with accounts payable) and long-term liabilities (as a separate line item). We include the liabilities for these leases in the company's capital structure (¥2.2 billion short-term plus ¥9 billion long-term liabilities as of 2/28/11). This group of leases includes both what the company calls "finance leases" and traditional operating leases. The treatment of these leases is the result of the company's compliance with the Accounting Standards Board of Japan Statement 13. Statement 13 was issued on 3/30/07 and requires that all "finance leases" be capitalized to recognize lease assets and lease liabilities on the balance sheet.

A third group of leases are also "financial leases" but predate the company's adoption of Statement 13 so they are not recognized on the balance sheet. The assets associated with these leases totaled ¥20.5 billion as of 2/28/10 and the liabilities associated with these leases were ¥23.2 billion as of 2/28/10 (the 2/28/11 figures have not been disclosed as of this writing). The following table summarizes 3337's lease related assets and liabilities:

3337 Lease Related Assets and Liabilities

For purposes of calculating the company's enterprise value, we include the two on balance sheet lease liabilities and the one off-balance sheet liability for a total of ¥34.5 billion. Note that we have not added-back annual lease costs to our EBIT and EBITDA figures, which makes these figures more conservative than they would be otherwise. If one wanted to add-back annual lease costs, one would not include the full leases costs (¥50.6 billion for the year ended 2/28/11), but rather, a subset of the annual lease costs comprised of the on and off balance sheet leases but excludes the real estate leases (since no liability for real estate leases is included in our Enterprise Value calculation).  We know that the company spent ¥8.6 billion to pay for the off-balance sheet leases, but they do not break-out the costs of the on-balance sheet leases (separate from total their total lease costs).

Things not to like about 3337

Before turning to what we like about Circle K Sunkus, here is what we don't like:

1.              As mentioned above, Circle K Sunkus's balance sheet is over capitalized.  While we do not advocate leveraged balance sheets, holding 75% of one's market capitalization in cash for a business that consistently generates positive free cash flow and has modest capital expenditure requirements is excessive. Some would argue that this is a sign of poor corporate governance and management's lack of shareholder focus.  We suspect, however, Circle K Sunkus's management team is simply overly conservative.  For instance, Circle K paid a ¥40 dividend for several years, which represented 60% of fiscal 2010 earnings and 35% of fiscal 2009 earnings, so management is returning capital to shareholders.  Also note that after three years of de-leveraging in the U.S., companies are building cash balances and reducing debt - this is a process that has been happening in Japan since 1990. Never the less, we would prefer that Circle K Sunkus reduce its cash balance by buying-back shares or a special dividend.

2.              About half of 3337's shares are held by UNY Co., Ltd., (8270 on the Tokyo Stock Exchange). UNY is a Japanese holding company that owns shares in a number of retail businesses. UNY's market capitalization is ¥140 billion, so its ownership of Circle K Sunkus represents 36% of its market cap. UNY does not publish its financial statements in English so we are reliant on secondary sources. It is our understanding the Circle K is its best asset.  Circle K Sunkus discloses related party transactions with UNY as "acceptance" of ¥24.5 billion of commercial paper- this is a large amount of money and we would prefer more detailed disclosure.

While we are on the subject of 3337's shareholders, here are its largest shareholders as of 2/28/11:

Circle K Sunkus Major Shareholders

3. Circle K Sunkus is lagging its peers on sales per store and year-on-year sales performance.

4. Along these same lines, Circle K Sunkus has not generated growing earnings since its formation in 2003. The following table summarizes the company's earnings, free cash flow, EBIT and EBITDA since 2003.

Circle K Sunkus Results since 2003

Another manifestation of the company's lack of growth has been its same store sales figures.

Mitigating 3337's performance in these metrics is its relative valuation (the company trades for about half the valuation of its Japanese peers and 1/3^rd the valuation of similar companies in North America) and its returns on capital (after adjusting for cash, 3337s returns are as good or better than its Japanese and North America peers).  Finally, we think we know why 3337's performance was especially weak in fiscal 2010, why it's performance improved in 2011 and why it may well improve this year, though we aren't asked to pay for any improvement based on its current valuation (if you can't wait for our explanation, please jump to the heading entitled "Business is improving" on page 9).

Things to like about 3337

There are five aspects of Circle K Sunkus we find attractive: 1) valuation, 2) they consistently generate good returns on capital 3) the nature of its business (what they sell and how they sell it) 4) their business is improving 5) they grow tangible book value even in difficult years.

Valuation

As mentioned above, Circle K Sunkus may be purchased for 0.8x tangible book value and about 2.5x trailing EBITDA - this is cheap for a well-capitalized business that consistently makes money. The company is also cheap when compared to its peers. The following tables compare 3337's valuation to similar companies in Japan and North America. 

Valuation of Circle K Sunkus and its Japanese Peers

The data in the above table indicate that Circle K Sunkus is currently valued about the same as its peers on an earnings basis, however, when we adjust for the company's extremely high cash position (e.g., EV/EBITDA), it is trading at about half the price of its Japanese peers.

Valuation of Circle K Sunkus and its North American Peers

Again, the data in the above table indicate that Circle K Sunkus is valued similarly on an earnings basis when compared to convenience store operators in North America, but when we adjust for its over capitalized balance sheet, it is trading for less than a third of the valuation of its North American peers. So does this mean 3337 is an inferior business?  The following tables compare 3337's returns on capital with similar companies in Japan and North America.

EBITDA / (Assets-cash): Japanese Convenience Store Industry

EBITDA / (Assets-cash): North American Convenience Store Industry

The data in both of these tables suggests that 3337's returns on capital are competitive with its peers after adjusting for its very high cash balances.

Circle K Sunkus's Business

Circle K Sunkus currently franchises 4,650 convenience stores and directly owns and operates an additional 351 convenience stores in Japan. In 1979, UNY Co., Ltd, licensed the Circle K name from Circle K Corp of the U.S.A. and founded the business. In 1993, UNY acquired all rights to the Circle K name in Japan. Nagasakiya Co. Ltd founded Sunkus in 1980.  By 1998 the two companies began a merger process which was completed, from a capital markets perspective, in 2004; full integration and harmonization of franchise agreements and merchandise was completed in 2008. The following table summarizes 3337's stores by franchise agreement type as of 2/28/11.

Under 3337's Type A franchise agreement, stores are financed and owned by the franchisee; the franchisee remits approximately 30% of the store's gross profit to 3337.  Under the company's Type E and Type C franchise agreements, 3337 rents the property and recruits the store manager to run the store; these stores remit, on average, 46% of gross profit to Circle K Sunkus. The following table summarizes Circle K Sunkus's merchandise mix for fiscal year 2011.

Merchandise Mix, 12 months ending 2/28/11

Note that food and tobacco comprise 85% of Circle K Sunkus's revenue and, given the markups, substantially all of the companies profit. This is attractive because the company is making money selling consumer staples, i.e., there is little chance that people will stop eating and smoking.

Business is improving

As discussed above, 3337's business has deteriorated slightly since 2003, however this may be changing.  Consider the data in the following table:

The data in the table indicate that fiscal 2011 was substantially better than 2010.  Interestingly, March 2011 same store sales (post earthquake and tsunami) were up 5.5% over March 2010.

If we ignore the surge in sales immediately before the tobacco tax hike effective 10/1/10 and the subsequent fall during November and December, Circle K Sunkus's same store sales have been steadily improving since July 2009; interestingly, we are not being asked to pay for this improvement. But what drove the business contraction during fiscal 2010? Starting in Q408, Japan's manufacturing industry began to suffer from higher input prices, collapsing global demand and a rising yen - this was dubbed the "Toyota shock." Among Japanese convenience store operators, Circle K Sunkus was particularly vulnerable to the Toyota shock due to the concentration of its stores in the Tokai region of Japan. The following table summarizes the location of 3337's stores over the last three years.

Circle K Sunkus Stores by Geographic Region

The table shows that 35% of 3337's stores are located in the Tokai region. Tokai is a major center of manufacturing:  44% of all cars produced in Japan, 53% of aircraft parts, 49% of machine tools, 64% of memory chips and 50% of LCD components are produced in the Tokai region. In short, Tokai was the center of suffering from the "Toyota shock."

There is little evidence of long-term decline of Japan's manufacturing capabilities. It also appears that the worst of the Toyota shock is over and conditions are now improving. Even so, 3337 is modestly priced based on fiscal 2010's depressed results (e.g., 2.8x FY 2010 EBITDA) and the business actually grew tangible book value through the crisis. The following table summarizes Circle K Sunkus's book value growth since 2003.

Circle K Sunkus Book Value

Japan's CPI is down marginally since 2003, a symptom of the deflationary spiral Japan has been in since 1990. Regardless, Circle K Sunkus continued to generate positive earnings and cash flow, paid dividends and increased tangible book value during this period yet is priced for Armageddon.  We conclude that 3337 is likely to prove be a good bargain at ¥1,242 per share.

Catalyst